How smart beta indices can boost returns

In the competitive world of professional investing, debate naturally rages on the best strategies to offer investors.

For example, within the actively managed space (where investors try to outperform an index) there is debate on the merits of growth versus value strategies in picking stocks. And across the whole market there is debate on the merits of actively managed strategies in general compared to more passive approaches (ie following an index).

But even in the world of passive investing there is debate over the best indexing strategy to pursue. The traditional approach is to include stocks within an index based on their market capitalisation. This is the basis upon which most of the world’s major sharemarket indices are constructed, such as Australia’s S&P/ASX 200, and America’s S&P 500.

Against this, however, are a growing number of so-called “smart beta” strategies, where non-market-capitalisation index weighting approaches are used.

Equal-weighting approach

For example, perhaps the simplest smart beta strategy is to use an equal-weighted approach, where each stock to be considered within an index is given the same weight. Such a strategy reduces concentration risk among large-cap stocks and breaks the nexus between index weight and a stock’s market price.

Of course, there are a vast array of other smart beta strategies including, for example, weighting stocks according to volatility or “quality” fundamentals, such as low debt, high return on equity, and earnings stability.

Another strategy – as followed by the BetaShares FTSE RAFI Australia 200 ETF (ASX: QOZ) – involves weighting stocks according to non-market-capitalisation measures of their economic size, such as total sales, earnings, book value and dividends.

The popularity of smart beta indices (SBIs) stems from the fact that it seems possible, often without much extra cost or complexity, to create an index with better, or at least different, risk-and-return characteristics than that of traditional market-capitalisation weighted indices (MCWIs) that may better suit the needs of certain investors.

SBIs, which attach a higher weight to low volatility stocks, may suit investors uncomfortable with the degree of return volatility normally associated with the sharemarket (as typically measured by a MCWI). Other investors may prefer an index that gives a higher weight to dividends, even if their higher income return might come at the expense of somewhat reduced capital growth over time.

And some investors might prefer reduced concentration risk through an equal-weighting strategy, even at the expense of broader economic representation.

Indeed, smart beta advocates contend there is nothing intrinsically “normal” or “proper” about using market capitalisation as the only “rule” by which to create a transparent index of stocks.

One obvious concern with MCWIs, for example, is that the weight they attach to a stock increases along with its price. That can mean over-valued stocks vulnerable to a correction are given added weight, while cheap beaten-down stocks poised to recover are given too little weight.

Note that when it comes to Exchange Traded Funds (ETFs), ASX does not make a distinction between traditional MCWIs and their SBI alternatives. Provided a fund manager tracks a strictly defined rules-based indexing strategy, their fund can be considered an ETF that tracks a particular index.

Understand the risks

Of course, smart beta strategies have their critics. Defenders of the traditional MCWI approach, for example, suggest that to the degree some SBIs appear to outperform over certain periods, they may reflect a particular style bias that is not able to outperform over the long term.

An equal-weighted index, for example, will tend to perform relatively well when smaller-cap stocks are tending to do well. Similarly, indices that favour value or stocks with high dividend yield will tend to perform relatively well when such investment themes are being favoured by the market.

Another criticism is that some carefully constructed SBIs may suffer from look-back bias, to the extent they cherry-pick stock selection criteria that happens to create impressive backward-looking performance compared to MCWIs, but can’t outperform thereafter.

In terms of claiming an ability to “beat the market”, some of these are valid criticisms, especially where some SBIs are indeed tied to investment styles or selection criteria that do not appear to consistently beat MCWIs over time.

That said, to the extent an investor is looking for an easy and cost-effective way to tactically overweight an investment style or theme for a limited period of time, even style-dependent SBIs have their place. In this sense, products based upon style or theme-dependent SBIs simply broaden the number of ways an investor can play the market.

To the extent that some SBIs only claim to offer a different mix of risk-and-return characteristics than MCWIs, SBI critics are on even shakier ground. After all, what is wrong with an index that consistently offers a relatively high dividend yield, or relatively low volatility, compared to that of a MCWI, if that is what an investor prefers?

Smart beta and outperformance

Last but not least, there is compelling historical evidence to suggest some rules-based strategies have the potential to consistently beat MCWI returns over time, or at least produce similar returns with lower volatility. These strategies are successful to the extent they exploit persistent market mispricing over time.

For example, the fundamental weighting indices adopted by the BetaShares FTSE RAFI Australia 200 ETF and the FTSE RAFI US 1000 ETF have, to date, beaten their counterpart MCWIs over long periods of time because they exploit the tendency of the market to regularly push stocks above and below their underlying values over market cycles.

All up, the key issue for investors is not necessarily which indexing strategy is best; rather, which investment strategies seem most capable of meeting their particular risk-and-return objectives in as cost-effective and transparent manner as possible.

For some investors, simple exposure to MCWIs might suffice. For others, the particular risk-and-return features of tailored non-capitalisation weighted SBIs may be more appealing, either as a complement or alternative to a traditional MCWI exposure.

About the author

David Bassanese is chief economist of BetaShares @BetaShares, one of Australia’s leading providers of exchange-traded funds (ETFs).

This article appeared in the July 2016 ASX Investor Update
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This article appeared in the July 2016 ASX Investor Update email newsletter. To subscribe to this newsletter please register with MyASX.

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